There are several types of brokerage accounts that you can invest in. You can open either a taxable or a tax-advantaged brokerage account, such as a regular or Roth IRA.
If you have a tax-advantaged account, you may either deduct the amount you contribute to the account in the year you invest (in the case of a traditional IRA) or remove funds tax-free (in the case of a Roth IRA). You will also not be taxed as the money in your account rises.
If you have a taxable account, though, the rules work differently. Not only do you not get any tax savings either when you contribute to the account or when you make withdrawals, but you also have to pay taxes in certain circumstances as your account balance grows.
So, when exactly do you have to pay taxes on the money in your brokerage account? Here’s what you need to know. When you have a taxable brokerage account, you will have to pay taxes if you make a profit on your investments when you sell them.
Say, for example, you buy $1,000 worth of a particular stock and the value of your shares goes up and your investment is now worth $2,000.
If you don’t sell and pocket the $1,000, you will not owe taxes on that $1,000 gain. If the stock’s value goes back down before you sell and you only end up with $1,200 worth of shares at the time when you unload your shares, you’d be taxed only on the $200 in gains you actually made when you sold the asset.
The gains you make “on paper” don’t count and aren’t taxed, since you don’t actually have that money yet — and you potentially may never get it, as the financial markets fluctuate.
Here’s how much tax you’ll have to pay
The amount of tax you have to pay when you sell your investments at a profit will be based on how long you hold the stock. If you held the stock you made a profit on for a year or less, you will be taxed at your ordinary income tax rate. Your gains are just treated as regular income.
But if you own the asset for longer than a year, you’ll be taxed at the more favorable long-term capital gains tax rate. The table below shows what your long-term capital gains tax rate would be.
| Tax rate | Single filer | Married filing jointly | Head of household |
|---|---|---|---|
| 0% | $0-$44,625 | $0-$89,250 | $0-$59,750 |
| 15% | $44,626-$492,300 | $89,251-$553,850 | $59,751-$523,050 |
| 20% | >$492,300 | >$553,850 | >$523,050 |
You are also allowed to deduct losses to offset your gains. So, for example, if you made a profit of $1,000 on one stock but lost $200 on another, you would typically pay capital gains taxes only on $800 in profits.
The rules can be a little confusing as to exactly what losses can be deducted from and what expenses you can deduct. And aside from capital gains taxes, you may owe taxes on dividends and interest received in your taxable brokerage account. However, most tax-filing programs can help you figure out exactly what your tax liability will be — or an accountant can help too.
The bottom line, though, is that you won’t have to worry about paying taxes on profits when your investments perform well in your brokerage account — until you sell them. And your taxes will be a lot lower if you hold your investments for more than a year.
Are Brokerage Accounts Taxable?
Some brokerage accounts, such as specific types of retirement accounts, provide protection against taxation. Many people open individual retirement accounts (IRAs) at brokerage firms in order to avoid taxes on brokerage account investments until withdrawal, or forever.
- Tax-deferred accounts. A traditional IRA is one of the most common types of tax-deferred brokerage accounts. You contribute pre-tax dollars to a traditional IRA, and then pay ordinary income taxes on the money you withdraw in retirement. You might use tax-deferred accounts to benefit from tax arbitrage. For example, let’s say you’re currently in the 24% marginal tax bracket, and expect to be in the 12% marginal tax bracket at retirement. It makes sense to use a traditional IRA to avoid paying 24% on your contributions now and pay just 12% on your withdrawals later. (Most 401(k)s, 403(b)s, and other employer-sponsored accounts are also tax-deferred accounts.)
- Tax-free accounts. A Roth IRA is one of the most common types of tax-free retirement accounts. You contribute post-tax dollars to a Roth IRA, and as a result, any of your withdrawals in retirement are not taxed. Even if you had $5 million of gains in a Roth IRA, you could withdraw them without paying a dime in taxes at retirement. Importantly, you’ll need to pay attention to Roth IRA income limits. These may rule out some people from using a Roth IRA to save for retirement. It’s also important to note that some employer retirement plans offer Roth options, such as a Roth 401(k).
Regardless of whether you choose Roth or traditional IRAs, investing in a tax-advantaged account gives you a huge advantage: You are only taxed on withdrawal (traditional IRAs) or before you make a contribution (Roth IRAs). In contrast, in a taxable brokerage account, you’ll owe taxes on brokerage account earnings at every step.
Roth vs. traditional IRA
Deciding between a Roth or traditional IRA can be tricky because you need to predict a number of different variables. To make a perfect decision and avoid taxes on brokerage account earnings, you’d need to know your income, marginal tax bracket, and investment returns, now and into the future. If you’re five years away from retirement, you can project these kinds of things with relative precision. If you’re 40 years from retirement, it’s not so easy.
A common rule of thumb is that Roth IRAs are better suited to younger investors as an investment account for retirement. This is because they’re likely to earn more as they age, and could pay higher taxes in retirement than they do in the present.
Roth IRAs also have some other important advantages, like the ability to withdraw your original contributions (but not any investment gains) at any time for any reason without penalty. This is helpful if you need to withdraw money for an emergency, for example. Roth IRAs don’t have any required minimum distributions (RMDs), while traditional IRAs require you to start taking out money at age 73, according to current law.
Read Also: How do You Set Up Tax Yield Income?
Soon-to-be retirees are likely in their prime earning years and may be paying higher taxes now than they will in retirement. As such, a traditional IRA might suit them better. Some people divide and conquer, putting part of their savings in a Roth account and another part in a traditional account so as to diversify their tax exposure. There isn’t a one-size-fits-all answer for how to approach Roth vs. traditional accounts.
If you’re new to investing, the main takeaway is that you’re likely to come out ahead by deferring or avoiding taxes on brokerage account investments. You can do so with a traditional IRA or a Roth account. Plus, tax-advantaged accounts save you some trouble at tax time compared to a taxable brokerage account.
Taxable brokerage accounts
An ordinary brokerage account that is not a retirement account is a taxable investment account. If you make money because your investments go up in value, or because your investments pay you dividends or interest, this income will be taxed. The taxes on brokerage account income depend on the type and source of the gains or investment income you earn. However, unlike retirement accounts, you can withdraw from your taxable brokerage account whenever you want, without any penalties.
Capital gains
The most basic way to make money investing is the old-fashioned way: by purchasing a stock, fund, or other investment and selling it later for more money. You know the mantra — “buy low, sell high.”
Money you earn from capital gains is taxed at different rates depending on how long you held the investment. Gains on investments you held for one year or less before selling them are “short-term capital gains.” The taxes on brokerage account short-term gains are taxed as ordinary income.
Holding an asset for more than one year gets you favorable tax treatment on the gains when you sell. For instance, if you buy a stock for $10, hold it for 18 months, and then sell it for $15, you will have $5 of long-term capital gains. Taxes on long-term capital gains can range from 0% to 20% depending on your tax bracket. But they’re almost always lower than what you’d pay on short-term capital gains or ordinary taxable income. This is to reward people for investing for the long haul rather than speculating on short-term price movements.
Dividends
Companies often pay out a portion of their earnings in the form of cash dividends to their shareholders to reward them for being part owners of a profitable business. Dividend income from your stock and mutual fund is taxed in two different ways. How dividends are taxed depends on the type of dividend you receive.
- Qualified dividends. The vast majority of dividends paid by public companies are qualified dividends. This means they qualify to be taxed as a long-term capital gain. There are certain rules about how long you must own a stock to benefit from the lower tax rate on qualified dividends. But the key thing is that qualified dividends are taxed at lower, long-term capital gains tax rates.
- Unqualified dividends. Some companies do not pay corporate taxes on their profits, and thus the dividends they pay to investors are “unqualified dividends” that are taxed as ordinary income. This generally applies to real estate investment trusts (REITs), master limited partnerships (MLPs), and business development companies (BDCs).
Interest income
You may earn interest on any investment, and you’ll generally pay taxes on brokerage account interest income. This could be from a bond, certificate of deposit, or just from holding cash in your brokerage account, the income is generally taxed as ordinary income. There are two common exceptions to this rule, however.
- U.S. Treasuries. If you lend money to the U.S. government by purchasing U.S. Treasuries, the income you earn is taxed at the federal level, but it is not subject to state or local income tax.
- Municipal bonds. Interest earned from municipal bonds is generally exempt from taxation at the federal level. In many cases, it’s also exempt from state and local taxes, resulting in no tax liability for the investor.
Any income you earn in a taxable brokerage account is taxed when the income is realized. If you sell a stock at a gain, that gain is taxable. If you earn interest on your cash balance, that interest income is taxable in the tax year in which it was received.
Many people falsely believe that any gains or income earned in a taxable brokerage account are not taxable until withdrawn, but that isn’t the case. You’ll pay taxes on brokerage account income in the tax year you earn it. What matters for taxable brokerage accounts is when the money is earned or gains are realized, not when it is withdrawn and enjoyed.
Most investors use taxable brokerage accounts only if they have already maxed out all of their tax-advantaged investment opportunities. For example, if you are currently maxing out a 401(k) at work, and an IRA you set up yourself, you might then consider opening a taxable brokerage account. This might allow you to save and invest even more money each year. If you’re maxing out your 401(k), but haven’t yet opened an IRA and want to avoid paying taxes on brokerage account earnings, an IRA is likely a better bet.
How do Brokerage Accounts Work?
A brokerage account allows you to buy stocks, bonds, and mutual funds. You can deposit money into a brokerage account in the same way that you would a bank account. Brokerage accounts do not have any contribution limits or early withdrawal penalties. They provide flexibility but lack the tax benefits of retirement accounts.
You can open a brokerage account quickly online. Many brokerage firms allow you to open an account with no up-front deposit. However, you will need to fund the account before you buy investments. You can do that by moving money from your checking or savings account, or from another brokerage account.
You own the money and investments in your brokerage account, and you can sell investments at any time. The broker holds your account and acts as a middleman between you and the investments you want to buy.
There is no limit on the number of brokerage accounts you can have, or the amount of money you can put into a taxable brokerage account each year. There should be no fee to open a brokerage account.
How to choose a brokerage account provider
There are two main options for where to open a brokerage account: online brokers and robo-advisors. Both offer retirement accounts and taxable brokerage accounts.
“You want to be careful with which company you open your brokerage accounts with,” says Wendy Moyers, a certified financial planner at Chevy Chase Trust in Bethesda, Maryland. “And you should be walking in with an awareness of what you’re going to be investing in. You want to do a little research.”
Online brokerage account
If you want to purchase and manage your own investments, an online brokerage account is for you. An account with an online brokerage company enables you to buy and sell investments through the broker’s website. Discount brokers offer a range of investments, including stocks, mutual funds and bonds.
Managed brokerage account
A managed brokerage account comes with investment management, either from a human investment advisor or a robo-advisor. A robo-advisor provides a low-cost alternative to hiring a human investment manager. These companies use computer programs to choose and manage your investments for you, based on your goals and timeline.
Robo-advisors may be a good fit for you if you’d like to be largely hands-off when it comes to your investments. We have a full list of the best robo-advisors.
Brokerage accounts are taxable accounts
The act of opening a brokerage account doesn’t mean you’ll be on the hook for any additional taxes. But brokerage accounts are also called taxable accounts, because investment income within a brokerage account is subject to capital gains taxes. Retirement accounts (such as IRAs) have a different set of tax and withdrawal rules. They may be better for retirement savings and investing.
“A lot of people think that brokerage accounts are ‘non-tax advantaged,’ but there are tax advantages,” said Delyanne Barros, founder of Delyanne The Money Coach.
“The benefit of the brokerage account is leveraging the long-term capital gains tax,” she said in an email interview. “In order to do that you must be a long-term investor. That means you have to hold your investments for over a year. Not only will this help you capture the most favorable tax bracket, but it will likely result in better returns.” Depending on your taxable income and filing status, the long-term capital gains tax rate is 0%, 15% or 20%[1].
The key to reaping a brokerage account’s advantages, Barros said, is to stay invested, ignore the day-to-day stock market noise, “and go live your life.” Here are five brokerage account tax tips to keep in mind.
- If you buy stock through a brokerage account, you’ll probably have to pay capital gains tax if you sell it for a profit later.
- If you sell a stock a year or less after buying it, you may have to pay the short-term capital gains tax. It’s usually your ordinary income tax rate, and often higher than the long-term capital gains rate.
- If you sell an investment for a loss, then you can use that loss to offset some of your gains and reduce your capital gains tax burden.
- If the stock or fund you buy through a brokerage account pays dividends, you’ll have to pay taxes on those dividends even if you choose to reinvest them. If this is the case, your brokerage will send the relatively uncomplicated DIV-1099 tax form to include in your tax return.
- If you invest through a retirement account, you typically won’t have to worry about any of this.
Final Thought
Whether you should open an IRA or taxable brokerage account first depends on your situation and investment goals. Financial planners often recommend, first and foremost, to contribute at least enough to a company’s 401(k) plan to earn the company’s match, if that’s a possibility.
If not, then it may make sense to open an IRA before a brokerage account, as IRAs come with considerable tax advantages and are built for long-term growth. If you have an IRA and are already maxing it out, and either don’t have access to a 401(k) through work or already contributing enough to at least get your company’s match, then a brokerage account could be the next step.
